Question

1. The Tax Cuts and Jobs Act of 2017 is a major overhaul of the tax codes in nearly three decades: it has generated a lot of debates on its potential impacts on economic growth, budget and sustainability, and equality and fairness etc. For our purpose, focus your discussion on the corporate side:

1. What would be possible impacts of some of the specific provisions on the corporate FCF, WACC, and Valuation?
2. What would be the possible impacts of some of the specific provisions on a firm’s capital structure decisions, i.e. the choice of debt vs. equity financing?
3. How have corporations used their tax cut money? Did they act as intended?

Answer 1

On December 22, 2017, President Donald Trump signed into law the bill known popularly as the “Tax Cuts and Jobs Act” (TCJA). The TCJA made changes to both the individual income and corporate income tax, while scaling back the estate and gift tax. Over the next decade, we estimate that the TCJA will reduce federal revenues by about $1.8 trillion on a conventional basis. In addition, the TCJA is projected to improve the incentives to work and invest, boosting the size of the economy. We estimate that the economy will be about 2 percent larger than it otherwise would have been between 2018 and 2027.

The reduction in tax liability will boost taxpayers’ after-tax income. However, the tax law’s impact on taxpayers each year over the next decade will vary due to the phase-in and phaseout of many provisions and, most notably, the expiration of most of the individual income tax cuts. While most taxpayers will see a tax cut in 2018, many will end up seeing a tax increase by 2027 if the individual income tax cuts expire as scheduled.

In addition, the larger economy will also mean higher incomes for taxpayers. However, the economic effects of the tax law will take time to materialize. As a result, individuals’ after-tax incomes due to higher wages and capital income will not occur immediately. Rather, they will gradually increase over the next decade.

(a) possible impacts of some of the specific provisions on the corporate FCF, WACC, and Valuation

The sweeping modifications to the Internal Revenue Code include a much lower corporate tax rate, changes to credits and deductions for both businesses and individuals, and a move to a territorial system for corporations that have overseas earnings. The significant overhaul will have immediate and long-term implications on valuations of businesses, equity, and related assets and liabilities, as entities continue to assess the impact on corporate strategy, acquisitions, and financial and tax reporting. We expect it will take buyers time to fully assess the impact of the Act. Investors appear to view the changes positively, and major stock exchanges have reached record high valuations in part due to the anticipated tax changes. Nevertheless, some market participants have taken a waitand-see approach and have not incorporated the expected tax changes explicitly into their deal models. The longerterm impact on individual companies will likely take time to assess given the complexity of the Act, likelihood of future changes to the Act and potential adjustment to operating models implemented by management teams in response to the Act. The basic approach to measuring value from a market participant perspective in an orderly transaction has not changed. Therefore, assessing the impact of the tax law change requires consideration of the factors that market participants would evaluate when transacting in an asset. It would not be appropriate to use a simplified approach by only changing the tax rate used and assuming that other inputs remain constant. Similarly, it would not be appropriate to selectively include the impact of the Act on parts of the analysis, such as the after-tax cash flows, but not in others, such as the cost of capital. Due to the complexity of the changes, it is important to consider all of the implications when updating valuation analyses. The effects of the Act when using various valuation approaches are discussed in further detail in the subsequent sections of this document. Ultimately, the many impacts of the Act on each company will continue to depend on individual facts and circumstances.

Before exploring the effects of the act on the cost of capital, it’s important to remember the components of the discounted cash flow (DCF) valuation model.

DCF value is a function of expected future net cash flows (the numerator) and present- value factors (the denominator) which are a function of the estimated cost of capital or the discount rate.

The act will generally increase the available net cash flows for businesses, increasing the numerator in a DCF model and thus leading to greater value. The recent run-up in stock prices(preceding their more recent crash) was generally driven by the expectation that net cash flows will increase, allowing for increased return of profits to shareholders (in the form of increased dividends and stock buybacks).

But the impact on the cost of capital is more complicated.

The cost of equity capital, in its simplest form, is typically expressed as a function of the risk-free rate, a market risk factor known as “beta”, and the equity risk premium, which is the equity return that investors demand to compensate them for investing in a diversified portfolio of large common stocks rather than investing in risk-free securities.

The Federal Reserve has started implementing what the financial press have coined “QExit,” a reduction in the Fed’s massive holdings of mortgage-backed securities and U.S. Treasury debt. Those holdings were designed to keep long-term interest rates down, thereby holding down the cost of equity capital. Now the Fed has determined that the economy is strong enough for interest rates to return to more normal levels, which will progressively lead to an increase in the cost of equity.

Beta risk is a function of business risk and financing risk. To the extent that business investment is financed by debt capital, beta risk increases. But that risk is partially mitigated by the tax deductibility of interest expense, reducing the true cost of interest expense. The act will increase the true interest cost by reducing the income tax savings due to the deduction of interest expense in calculating taxable income.

For example, assume a business has $10 million in interest expense. At a 37% income tax rate, the true cost of debt capital is $10 million x (1 – 37%) = $6.3 million. But at a 21% income tax rate, the true cost of interest is $10 million x (1 – 21%) = $7.9 million, increasing the true cost of debt capital by 25% and increasing the financial portion of beta risk.

However, one also needs to consider that a business may have some portion of their operations and profits earned in countries outside of the United States. That makes it important to consider all the relevant taxing jurisdictions in assessing a company’s global effective tax rate and consequent interest tax shield.

Finally, the weighted average or overall cost of capital to the business is a function of both the cost of equity capital and the cost of debt capital based on their proportionate amounts in the capital structure.

We’ve already seen that the combined actions of the Fed and Congress in enacting the new tax law will likely increase components of the cost of equity capital and increase the true cost of debt capital.

A newly-introduced provision will further reduce the value of interest tax shields, thereby further increasing the after-tax cost of debt. The act caps the ability by corporations to deduct interest expense above certain thresholds.

For businesses with revenues of more than $25 million, the interest deduction for years 2018 through 2021 is capped at 30% of “adjusted taxable income,” which is similar to earnings before interest expense, income taxes, depreciation, and amortization (EBITDA).

Thereafter the interest deduction is capped at 30% of “adjusted taxable income,” whose definition then switches to a measure similar to earnings before interest and income taxes (EBIT). These limitations will cause the cost of debt capital financing to increase even more.

Thus, for many larger businesses that have grown accustomed to relying on debt capital financing, their weighted average cost of capital will likely increase as result of The act.

(b)possible impacts of some of the specific provisions on a firm’s capital structure decisions, i.e. the choice of debt vs. equity financing

The Tax Cuts & Jobs Act of 2017 (TCJA) placed limitations on the deductibility of interest for U.S. firms. Using a difference-in-differences design examining both affected and unaffected firms, we show that following the enactment of the new limitations, affected firms significantly decrease corporate leverage. Specifically, we find that relative to unaffected U.S. firms, affected firms experience a decrease in leverage of 2.9% of assets; corresponding to about $126 million per firm and $29.8 billion aggregated over our full sample. This represents a debt decrease of 5.8% relative to the average debt to asset ratio for the pre-TCJA affected sample. We find similar results using a triple differences design, which benchmarks debt trends in the U.S. to those of unaffected and pseudo-affected Canadian firms that would be subject to the limitation had they been U.S. firms. These results are driven by decreases in long-term domestic debt and by declines in new issuances rather than repayment of existing debt. Robustness tests indicate other elements of tax reform do not influence the results. We also find firms not currently subject to limitations on interest but subject to future limitations decrease leverage by about half as much as firms currently subject to interest limits.

(c)

For corporations, the recently-enacted Tax Cuts and Jobs Act packs a significant punch in terms of tax advantages. Most notably, the dramatic reduction in corporate tax rates and the elimination of the Alternative Minimum Tax will enable corporations to hold on to more of their revenue.  

However, the TCJA is a mixed bag, and many companies will find that its advantages are counterbalanced by other provisions that may minimize any tax savings. Companies in certain industries will do better than others, and companies with a certain mix of expenses, deductions and credits also will do better than others.

Broadly, the TCJA benefits corporations more robustly than it does individuals, in that its reduction in tax rates is much larger, and the benefits for corporations that are built into the law are permanent.

Following is an overview of the most significant provisions of the TCJA on corporations. In the coming months, we will inform you further about specific impacts of the new law on certain types of businesses.

New corporate income tax rates

For tax years beginning January 1, 2018 or later, the corporate tax rate has been simplified to a flat corporate tax rate of 21%. This removes the former tiered corporate tax rate structure approach of 15% to 34% for corporations with up to $335,000 in revenue, and 34% to 35% above $335,000. Corporations with non-calendar fiscal years will have a blended tax rate for the first year. For example, companies with a March 31 year end will have nine months at the old rate and three months at the new 21% rate.

Alternative Minimum Tax (AMT) for corporations repealed

Prior to the TCJA, the corporate alternative minimum tax (AMT) was at a 20% rate, but corporations were exempt if they had average annual revenue under $7.5 million. Beginning in 2018, the new law repeals the corporate AMT. For corporations that paid the corporate AMT in earlier years, an AMT credit was allowed under prior law. The new law allows corporations to fully use their AMT credit carryovers, and the credit may be refundable.  

Bonus depreciation rules enhanced

For qualified property acquired between September 28, 2017 and December 31, 2022, bonus depreciation of 100% is allowable; previously 50% was allowable. This will ratchet down by 20% each year through December 31, 2026, and will be eliminated in 2027. Bonus depreciation now applies to used qualified property, prior to September 28, 2017 property had to be new.

New limits on business interest deductions

With certain exceptions, interest paid or accrued by a business generally was fully deductible under previous law. Under the TCJA, affected corporate and non-corporate businesses generally can’t deduct interest expenses in excess of 30% of “adjusted taxable income,” starting with tax years in 2018. (For S Corporations, partnerships and LLCs that are treated as partnerships for tax purposes, this limit is applied at the entity level rather than at the owner level.)

For tax years beginning in 2018 through 2021, adjusted taxable income is calculated by adding back allowable deductions for depreciation, amortization and depletion. After that, these amounts aren’t added back in calculating adjusted taxable income.

Business interest expense that’s disallowed under this limitation is treated as business interest arising in the following taxable year. Amounts that cannot be deducted in the current year can generally be carried forward indefinitely.

Note: Corporations with average annual revenue less than $25 million are exempt from the interest deduction limitation.

Employer deductions for business meals and entertainment

Prior to the TCJA, corporations generally could deduct 50% of expenses for business-related meals and entertainment. Meals provided to an employee for the convenience of the employer on the employer’s business premises were 100% deductible by the employer and tax-free to the recipient employee. Various other employer-provided fringe benefits were also deductible by the employer and tax-free to the recipient employee.

Under the new law, starting in 2018, deductions for business-related entertainment expenses are disallowed. Meal expenses incurred while traveling on business are still 50% deductible, but the 50% disallowance rule will now also apply to meals provided via an on-premises cafeteria or otherwise on the employer’s premises for the convenience of the employer. After 2025, the cost of meals provided through an on-premises cafeteria or otherwise on the employer’s premises will be nondeductible. Meals in conjunction with entertainment are now nondeductible.

Research and development (R & D) expenses modified

In the past R & D expenditures were expensed as incurred and certain companies who qualified could take advantage of R & D tax credits. The R & D tax credits have remained intact, but some changes have been made to the R & D expenditure rules. Under the new tax bill, starting in 2023 R & D expenditures must be capitalized and amortized over five years, and certain R & D expenditures which are attributable to research conducted outside the U.S. are required to be capitalized and amortized over 15 years.

Domestic Production Activities Deduction (DPAD) eliminated

The DPAD deduction (under IRS code section 199) which reduced taxable income (or qualified domestic production activities income) by approximately 9% has been eliminated. The provision is effective for corporations for tax years beginning in 2018.

Net Operating Loss (NOL) rules modified

In the past NOL carrybacks were allowed for up to two years, and carryforwards were allowed for up to 20 years. Under the new tax law, for losses arising in 2018 or beyond, NOLs may no longer be carried back. NOL carryforwards are now carried forward indefinitely subject to an annual limitation of 80% of taxable income. Important note: There is no small business exemption for the C Corporation NOL limitation.